The $100M USD+ Bitcoin market is experiencing its first major inflationary event. There's great volatility, but since Friday's drop of 15 percent, the trend has been a reduction in value versus the USD. (Source: Mt. Gox)

In some way Bitcoins are like traditional currency, in other ways, they bear more similarity to publicly traded stock. Many individuals are using them to buy and sell goods or services, though, just like a standard currency. (Source: Life Hack)

Bitcoin miners can make a tidy profit by pushing early adoption, but market volatility creates a level of risk. (Source: WCCF Tech)

Bitcoin protects the users' anonymity with sufficient IP obfuscation. However, it cannot hide the real world trail of physical transactions, some purchases leave. Thus using Bitcoins to purchase illegal substances is a risky proposition as real world shipments of goods are most definitely traceable. (Source: AP Photo)

Bitcoins are an exciting development as they offer a unique new economic mechanism. However, the movement faces a number of risks to its goal of becoming a legitimate, widely used currency. (Source: Nerd Merit Badges)

Over the weekend there was more movement in the Bitcoin market, and much confusion about the peer-to-peer currency remains. In this follow up we'll take an objective look at what we feel the true story of Bitcoin is.

I. Is the Bitcoin "Recession"/"Depression" Over?

The market on Sunday showed signs of recovery. With the world's largest exchange, Mt. Gox opening at $14.75 USD/Bitcoin, the price has floated up to $20.14 USD/Bitcoin [source]. That's a massive 36.5 percent upward shift (in a deflationary direction). (The market has since receded slightly to $19 USD/Bitcoin.)

On the other hand, after the Bitcoin "Black Friday" the market is now down 30.3 percent thanks to another major dip on Saturday (this shift is in the inflationary direction).

Last, but not least, if you look at Bitcoin trading over the last month it's seen rampant deflation, with prices soaring from around a dollar in mid-May to current levels -- nearly 20 fold deflation.

So what does all this mean? In short, it indicates that there is a great deal of volatility in the Bitcoin market. Part of this arises out of media coverage of the crypto-currency. Part of it is based on the growing pains of an experimental currency that's still in the proving stages.

II. Are Bitcoins Currency?

Ostensibly, the answer is yes, Bitcoins are a peer-to-peer internet-driven cryptocurrency. However, Bitcoins' unique nature means that they have many critical differences from standard currency.

First, the originators of the Bitcoin market didn't want to take the 100+ years that most modern currencies required to mature. To that end they "seeded" the market, by granting ownership "miners" -- people who used hardware to "find" Bitcoins using an underlying algorithm.

In this regard Bitcoins are a bit like land stakes. If you get in early and have the proper resources (hardware) you can lay stake to a large Bitcoin claim. For example, the "father" of Bitcoins, Satoshi Nakamoto reportedly has around 150,000 Bitcoins (~$3.0M USD) [source] out of around 6.518m Bitcoins currently in existence.

On the other hand, the rapid growth in value of Bitcoins comes thanks to their utility (more on that late). In that regard, they behave much like a stock. Much as a stock -- say shares of Apple, Inc. (AAPL) -- can rise dozens-fold on news and speculation, Bitcoins can see a great deal of volatility and offer great payoff to early adopters at the cost of great risk.

Bitcoins can be used to purchase real world goods and services among willing merchants. And they are housed in "accounts" -- cryptography protected digital records. In that regard they are much like currency.

Traditional currencies typically originated based on the barter of commodities (such as gold or animal pelts) then eventually evolved into a non-commodity based medium for making daily purchases. By contrast the creators of the Bitcoin movement hoped to remove the commodity stage. They instead created a currency that began as exchange object that could be traded with real world currencies, and evolved into a full fledged medium for selling and buying goods and services.

To summarize the complex answer to this question, currencies inherently imply a stable medium for everyday financial exchanges. For now Bitcoins satisfy the latter definition of currency, but not the former. In that respect they can be thought of as a hybrid of a "stock" and a currency, which should (in theory) evolve towards a pure currency in the long run.

III. Are Bitcoins Risky to Buy/Sell/Mine/Trade?

Bitcoin mining (building the Bitcoin economy via seeding) has shown itself thus far to be relatively safe. If you use current clients and hardware, you can generate Bitcoins at a competitive rate and sell them to break even off your hardware. After that, everything is pure profit.

Day trading Bitcoin currency, or accepting Bitcoins as a payment method is slightly more risky. Think of it as trading stock. You're unlikely to lose the majority of your value, but volatility could make it hard to instantly redeem your holdings in your nation's currency. Likewise, if your timing is poor (say if you bought into Bitcoins at $28 USD/Bitcoin on Thursday), you could lose a significant amount of money.

IV. What's the Reward of Bitcoins?

Bitcoins enjoy several advantages over traditional currencies. One of the biggest is the degree of anonymity they provide. While not completely anonymous, depending on the user's behavior, Bitcoins nonetheless offer a degree of privacy that's particularly affective in warding off cybercriminals or real-world enemies who might wish to target you for some reason.

Another advantage of Bitcoins is that they can be divided down to fractions 1e-8 -- one hundred millionth of a Bitcoin. That fraction is called a "Satoshi", in honor of the "father" of Bitcoins. By allowing currency to be divided to finer fractions, buyers and sellers have greater flexibility in sales and bartering.

Yet another advantage of Bitcoins is that they're not reliant on a single central monetary authority. Rather power is spread between individual users and Bitcoin exchanges. In this regard, they're not solely reliant on the financial success of an individual nation and, in theory, safer from concerted financial sabotage.

V. Is There a Bitcoin "Central Authority"?

Officially, no, there is not. One of the commonly spread notions about Bitcoins is that anyone can mine Bitcoins, anyone can use them, and anyone can start a Bitcoin exchange.

However, in practice it takes a bit of technical skills to mine, buy, sell, or accept Bitcoins. It takes much more effort to start a Bitcoin exchange and actually get people to use it.

Probably the closest thing to a "central authority" in the Bitcoin world are the major exchanges. If the major exchanges -- say Mt. Gox, bitomatPLN, virwoxSLL, britcoinGBP, bitmarketEUR, bcmPPUSD, and thUSD -- all decided to implement trading rules that made the market close upon a gain or loss of over 5 percent of the currency's value in a single day, the whole market would be greatly affected. (We suggest such a change in are previous piece.)

The exchanges have sufficient power to enact major changes because over 99 percent of the world's Bitcoin currency exchange volume is funneled through these seven exchanges.

In practice, if you "didn't like" these changes, you could go and start your own exchange. However, much like a business, it takes a lot of know how to start one, and it takes a lot effort to promote them. Few people have the technical competence to start a Bitcoin exchange, fewer still the time to start one. And even less people have the time to promote a new exchange. So at the end of the day, the aforementioned seven "major" exchanges hold a great deal of power over the currency's application.

Mt. Gox controls over 90 percent of the trading volume, so it's obviously the single most powerful entity in the Bitcoin world, by controlling Bitcoin currency exchange. In that regard its somewhat of a de facto authority, but its more of a community-elected power than a monetary policy dictator (unlike standard central banks).

VI. Is Bitcoin an International Currency?

Ostensibly yes, but in practice Bitcoins remain closely tied to the United States Dollar (USD). Mt. Gox accepts funds transferred from EuroWire, but traditionally it's been heavily driven via USD funds -- transferred using mechanisms such as Paypal, Dwolla, Lindens, or Liberty Reserve.

The Polish zloty and Euro (the European Union's currency) are two of the secondary most important currencies to the Bitcoin movement, though they reportedly drive a much smaller percent of the overall volume than USDs.

As time passes, Bitcoins will likely evolve into more of an international currency, but like most world currencies, they will likely be tied to the currency of the prevailing world economic superpower. That superpower used to be Britain; today it is the U.S.; and someday it may be China. But suffice it to say, the Bitcoin is unlikely to replace traditional currencies, so it will likely be closely tied to the "dominant" currency of its era.

VII. Are Bitcoins Anonymous?

Bitcoins are anonymous to an extent, via cryptographic mechanisms. However, transactions can be viewed on an IP level, thus anonymity is largely a measure of how well you hide your true location (your IP address).

If you use the address given to you by your internet service provider (ISP) for Bitcoin transactions, anyone with sufficient desire, technical savvy, and resources can probably trace you.

If you obfuscate your IP via Tor or other services, your anonymity greatly increases. However, physical transactions in the real world driven by virtual Bitcoin exchanges can still compromise whatever anonymity you maintained online.

At the end of the day, the answer here is that Bitcoins do offer you a bit more anonymity than, say, transactions using U.S. twenty dollar bills. How much more anonymity they offer varies, but nonetheless, they are not "untraceable" when used to buy real world goods and services -- not because they're traceable online, but because real world goods and services are inherently traceable.

VIII. Are Bitcoins Used to Buy Drugs? Is It Safe to Purchase Narcotics With Bitcoins?

Some people have used Bitcoins to purchase narcotics online.

That said, it is inadvisable to purchase narcotics or illegal services with Bitcoins. Narcotics are inherently associated with discrete real world transactions. You might think your Bitcoins are "untraceable", but a delivery of drugs from a known dealer sure isn't.

In this regard Bitcoins absolutely do not anonymize illicit, monitorable exchanges of goods and services. This is an extremely common misconception -- one held even by some U.S. Senators.

To understand this better, we shall present a short fictitious scenario. First, consider that a drug dealer may may ship crack cocaine to a person via the U.S. Postal Service, after a Bitcoin transaction. This transaction may go unnoticed by law enforcement. But the dealer is unlikely to only sell via Bitcoin. They probably will also sell to individuals on the street. Let us assume that after some time, they're caught and charged with a felony by police.

Next, consider that law enforcement officials decide to track the felon's IP activity. They discover that they're using Bitcoin marketplaces. Then the police may start monitoring their shipments. Finally, let's consider that one of these tracked shipments, containing a case of ecstasy pills gets delivered to your house. You think you're safe -- but you're not. Police have tracked the shipment and know you're in possession of narcotics. They raid your house, find the drugs and find you in possession of narcotics, and charge you. Not only that, additional charges may be tacked on for conspiring to deliver an illegal substance via the mail.

Police can track sales of illegal goods or services -- e.g. narcotics or prostitution -- via monitoring of real world exchanges and behavior. If you use Bitcoins to buy these kind of services, you stand a substantial risk to get caught, particularly as knowledge of Bitcoin use grows in the law enforcement community. As is typical with non-digital sales of these kinds of illegal items, the risk is thought to be somewhat lower if done from the privacy of your home. However, endemic offenses will likely be noticed and lead to arrests.

That said, the whole debate about Bitcoins and drugs is overstated. Bitcoins aren't about drugs or crime. They can be used for a great deal of legitimate purposes. Even if your main reason for using Bitcoins is anonymity, there's plenty of legitimate reasons to desire that -- to avoid government intrusions in your private life; to prevent other individuals (e.g. neighbors, your significant other, employers) from spying on you; and to prevent malicious individuals (such as hackers) from monitoring your activities.

IX. Are Bitcoins in Danger of Deflation?

Under the deflation scenario bitcoins are expected to continue to rise in value versus the USD. For example, some expect they may one day hit anywhere from $100 USD/Bitcoin to $1,000 USD/Bitcoin.

Traditionally deflation is very bad for a currency, because it means that people won't want to spend the currency because it's so "valuable". But this is largely an effect of the particular currency's limitations imposed by its smallest denomination. In other words, if the smallest unit of currency is a penny and a penny can buy you a video game, you may not want to spend much money as it's so valuable.

In traditional currencies deflation can have a disastrous effect on spending due to the reasons outlined above. However, Bitcoins offer divisions down to 1e-8 -- which currently has a value of around 20 millionths of a penny.

Thus the "Satoshi" -- the smallest unit of Bitcoin currency is unlikely to become significantly valuable even under the wildest deflation scenario. Thus, it's unlikely that people will hoard Bitcoins and that deflation will become a serious direct issue.

That said, if one thousandth of a Bitcoin is worth one USD, it may prove a psychological barrier that will dissuade casual participants. For that reason it may be desirable to offer more Bitcoins after the planned initial generation of 21 million Bitcoins.

It will be up to the community to try to figure out exactly how to implement this, nonetheless it may be possible to expand the number of coins that the eventual "mature" market will have in distribution.

X. Why Can't Paypal be Used for Bitcoins Anymore on Mt. Gox?

Paypal, a subsidiary of eBay, Inc. (EBAY), used to be accepted by Mt. Gox as a source of funds for purchases or sales of Bitcoins. Given the popularity of Paypal and the leading role of Mt. Gox, this was a major source of money transfers into and out of the exchange.

Recently, though, Mt. Gox banned Paypal. Some mistakenly believe this is due to insecurity or account theft on Paypal. In reality it's because of Paypal's policies. According to the Bitcoin wiki:

This is due to repeated cases where someone pays for Bitcoins with Paypal, receives their Bitcoins, and then fraudulently complains to Paypal that they never received their goods. Paypal too often sides with the fraudulent buyer in this case, and so exchangers no longer allow this method of funding.

Paypal most definitely would be a valuable ally to the Bitcoin movement and Bitcoin exchanges, however until they modify their policies to recognize and verify Bitcoin transactions, the majority of the community will have to move on without them. In the short term this seems unlikely to change -- Paypal has a policy against virtual currencies.

XI. Are Bitcoins a Good Idea?

Arguably, the answer to this is yes. They have several distinct advantages outlined above.

It's easy to dismiss them because they have failed to behave like a traditional currency during their initial distribution. That said, they have already succeeded in generating a currency worth more than $130M USD -- a value that approaches the GDP of a small nation.

Bitcoins offer the world's first digital-age currency. They reward early adopters uniquely, but they offer many benefits for supporters who come in at any point in the process.

That said, the market clearly is very volatile. In order to overcome these growing pains, the community and exchanges may need to agree upon certain trading rules to prevent bidirectional rapid inflation/deflation swings.

XII. Are Bitcoins Legal?

It appears that Bitcoins are currently legal under U.S. laws. There are no laws that outlaw the trade of non-U.S. currency, as long as it is not represented falsely as U.S. currency.

There are laws against unauthorized money exchange businesses [source]. However, the major exchanges like Mt. Gox are registered to individuals outside the U.S. in many cases and, further, may not qualify as a "business" as they charge a small fee (0.65% per trade) and do not make money off advertising.

As long as the exchanges are run as nonprofit entities, they appear to be legal -- even if they're operated within the U.S.

There has been recent pressure by Senators Charles Schumer (D,New York) and Joe Manchin (D, West Virginia) to shut down narcotics marketplaces that accept Bitcoins. That has led to fear that the government could next move against Bitcoin exchanges.

However, those fears are largely unfounded. Indeed, even the Senators' suggestion about the online marketplaces is full of misconceptions. For example they indicate that Bitcoin-driven narcotics sales are untraceable, which is simply not true, as outlined above.

XIII. What is DailyTech's "Agenda" w.r.t. Bitcoins?

DailyTech is a news site and its only agenda is to cover the news. Covering Bitcoins is a tough job as miners and those who support the movement are used to the media trying to discredit or destroy the movement, in some cases.

Our staffers do not currently hold any major Bitcoin holdings. Nor have we been contacted by any business or government agency to "discredit" Bitcoins.

Our analysis is independent and objective and is the result of a great deal of research. We welcome our readers' involvement and suggestions as many of them use or have experimented with the use of Bitcoins.

We are happy to provide commentary to other news outlets regarding these and other observations regarding this unique phenomena.

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Shut-downs and temporary freezes have nothing at all to do with free market principles, either for or against. They're safety measures. In a free market with perfect distribution of information, should anything REALLY fluctuate in value to the tune of 15, 20, or 30% in a matter of mere hours? Absolutely not, except, maybe, in the case of something sudden.. Like a continent exploding, or nuclear war.

So their intent is just to protect participants from themselves, and from the fact no free market is 100% free and perfect. Is the most recent trades intentional, for example, or, woops, did someone add an extra zero or two, or "sit on the sell button"? Is someone trying to manipulate the market unfairly? Is there an unknown technical glitch? Pausing the market gives participants, and the market operators, a chance to step back and make sure everything is proceeding rationally and as intended.

Would you rather have your ideological purity and see potentially erroneous wild fluctuations then a system that might say "Okay, this is extreme, we're shutting down trading for 30 minutes, and we'll look at the data in the mean time," or however they setup the circuit breakers?

If a market really wanted to rally, or sell, it'll still do it, just slower. Oil, I recall a couple years ago, traded "limit up" for days at a time. That didn't, in the scheme of things, really slow its rise.

The value set by people getting carried away in the heat of the moment in following buying/selling trends does not reflect the real value that a rational purchaser would assign. Putting limits on the market does not take away from this rational person reevaluating things, it merely prevents the dangerously destabilizing arbitrary wealth transfer of irrational swings.

"A politician stumbles over himself... Then they pick it out. They edit it. He runs the clip, and then he makes a funny face, and the whole audience has a Pavlovian response." -- Joe Scarborough on John Stewart over Jim Cramer